High-Quality Hidden Gems (Continued)

As previously discussed, to achieve superior returns, investors may want to look for stocks that are way under-covered. We continue our search for hidden gems, this time in the US market. US stocks are generally more liquid, receiving more exposures, which makes it harder for us to land on high-quality hidden gems. Be aware that liquidity is a positive factor and analyst coverage is a negative factor in my proprietary stock quality ranker. Additionally, US market is overvalued probably by all metrics, including this Warren Buffett Indicator. Therefore, we loosen the screening/filtering criteria a bit as followed:

  1. Return on assets: no less than 10% for the past 10 years;
  2. Return on equity: no less than 12% for the past 10 years;
  3. Return on invested capital: no less than 12% for the past 10 years;
  4. Net margin: no less than 5% for the past 10 years;
  5. Gross margin: no less than 30% for the past 10 years;
  6. Operating margin: no less than 10% for the past 10 years;
  7. Free cash flow margin: no less than 5% for the past 10 years;

Again, I put the screening result into my stock ranker which further takes into consideration factors, such as growth/momentum, industry/sector, shareholder friendliness, financial strength. Overall, my combination of screener and ranker gives high weights to managements’ capital allocation skills, profitability, and cash flow. Below are the top-ranked ones with limited coverages here in the Seeking Alpha community. We include their respective valuation analysis in the end.

Federated Investors (FII)

Since 1955, Federated Investors has been a leading provider of investment management products and related financial services and is now one of the largest investment managers in the U.S. with $397.6 billion in assets under management (AUM) at the end of 2017.

Source: Federated Investors Annual Report 2017.

The majority (more than 60%) of the AUM is held through money market strategies and/or products at Federated. The heavy emphasis on money market assets lends to a stable AUM revenue stream regardless of market volatility. Actually, the money market portion of the business is a hedge on stock market volatility as any sell-off in the stock market may contribute to money market investments as the safe haven. Moreover, the rising interest rate would benefit Federated’s money market funds due to less likelihood of the fee waiver program, which cost losses to the company for many years during the low-rate period.

Federated Investors employs a super capital-light business model, consistently generating high returns on capital over the past decade (see below) and currently earning 1195.8% return on tangible equity. The business produces strong free cash flow (around 28% FCF margin) for its owners and spends less than 1% CAPEX on sales.

Source: Morningstar; data as of 8/5/2018.

The dividend is safe regardless of the current high yield (4.5%), thanks to its strong balance sheet (i.e., 3.6x current ratio, 0.22 Debt/Equity).

There is limited coverage on FII here in the Seeking Alpha community, with only three articles on the stock for the past year and no article for the past two months. The share is currently trading at a discount if compared to its historical levels in terms of P/E, P/B, P/S, P/CF and dividend yield (see below). Hence, FII is a strong buy on our hidden gems list.

Source: Morningstar; data as of 8/5/2018.

NIC Inc. (EGOV)

NIC Inc. is the leading provider of digital government services that help governments use technology to provide a higher level of service to businesses and citizens and increase efficiencies. It was founded in 1992 and is now headquartered in Kansas with 950+ employees nationwide and partnerships with 6,000 federal, state, and local government agencies in the US.

Source: Investor Presentation 2018.

NIC takes a flexible approach to funding digital government solutions. While most enterprise partnerships are funded through a transaction-based funding model, others are funded through fixed fees or a hybrid of fixed fees and transaction-based funding. The transaction-based model saves taxpayers’ money on upfront development cost and generates recurring revenue whenever users enjoy the efficiency through digital/online services provided by NIC. It is a win-win solution for all parties (i.e., governments, taxpayers, NIC), benefiting from user population growth, government promotion, and service monopoly.

The long-term contract, high switch cost, B2G (business-to-government) relationship and niche market play get NIC a wide moat to it economic castle with high profitability and returns on capital (shown below).

Source: Morningstar; data as of 8/5/2018.

The company’s balance sheet is another reason investors should be comfortable with the stock: over 2x current ratio with no debt.

There are only four articles on EGOV stock in the Seeking Alpha community during the past year and only five analysts covering the stock according to WSJ.com. Like FII, the share is quietly trading at a discount if compared to its historical levels in terms of P/E, P/B, P/S and P/CF (see below). Hence, EGOV is another buy on our hidden gems list.

Source: Morningstar; data as of 8/5/2018.

Atrion Corporation (ATRI)

Atrion is a leading supplier of medical devices and components to niche markets in the global healthcare and medical industry. While it is a comparatively small company in the sector, Atrion is the leading U.S. manufacturer of products in several market niches, including soft contact lens disinfection cases, clamps for IV sets, vacuum relief valves, surgical loops used in minimally invasive surgery, and check valves.

The company has been and will be benefiting from the industry tailwind as the growth of health care spending is consistently exceeding the overall GDP growth (see below) due to the aging population.

Source: Statista.

The management team has done an exceptional job allocating capitals efficiently, indicated by a stable and high margin and return on capital (shown below). The business also maintained its typical profitability and growth during the 08/09 great recession, thanks to the recession-proof nature of the industry. The niche market play and sufficient R&D spending have been giving Atrion the durable competitive advantage.

Source: Atrion Corporation Annual Report 2017.

The stock (as shown below) has consistently outperformed the market benchmark and the sector benchmark. It has its track record of raising dividends consecutively for 15 years now, with a super clean balance (i.e., no debt, plenty of cash, and a current ratio of over 9x).

For the past 12 months, there has been only one article on ATRI in the Seeking Alpha community and no Wall Street analyst following the stock according to WSJ.com. Nonetheless, the valuation appears to be a bit rich if we compare the price multiples to their historical averages (see below P/E, P/B, P/S and P/CF). Therefore, we would like to put Atrion on our watch list for now.

Source: Morningstar; data as of 8/5/2018.

Summary

Warren Buffett once mentioned that he has confidence in getting as high as 50% returns on a small amount of money to invest in stocks. Likewise, we believe it is not hard to beat most investment funds with large scales or financial professionals. To achieve so, investors (especially those individual ones with a relatively small amount of investable fund) should take advantage of small caps with little popularity and coverage. Thankfully, size is not an advantage in the investment world and being popular or not has no correlation with investment results.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Joan Guzman